Tag Archives: funding costs

You can see the spread between dollar and euro Libor is upward sloping up to 6mths, then falls at the 1yr point on the curve. The question is why.

To answer that, I started looking at the points in the Libor curves to see what the trade-off was between maturities and basis points paid at the various maturities. So here are the charts, which I hope to explain in a cogent manner:

Here’s how I created these:

Collect rates at Libor curve maturities (o/n, 1mth, 3mth, 6mth, 1yr)

Calculate the basis point differences between the maturities (1mth-o/n, 3mth-1mth, 6mth-3mth, 1yr-6mth)

Plot over time. Voila.

Another way to view the data is to look at the basis point differentials as curves themselves. That’s what I did with these two:

Two things to note: I circled the rise in dollar Libor at the 3mth-1mth differential and the 6mth-3mth differential, but it’s also worth noting the rise between the 3mth-1mth and 1mth-o/n differentials, too. It shows me the fear in the dollar Libor market is squarely in the o/n-6mth time horizon, even while the whole curve has shifted upward. Meanwhile, euro Libor differentials have stayed anchored like a ship run aground with the exception of May 11, where o/n euro Libor spiked for some unknown/undisclosed reason. My guess then was that either a bank had a funding problem or someone else was really bidding overnight funding up, just to stay liquid for 24 hours. Either way, not a good sign.

Plus, the euro Libor curve shows a bit of a kink between the 6mth-3mth and 1yr-6mth differentials. It could be that there’s a preference to get 1yr funding over 6mth, but it’s hard to say.

At any rate, what we can conclude is pretty clear: dollar Libor is where the action is and until we see these differentials at the front end of the curve relax, the bear flattener is on.

If you remember, I wrote a post last week that looked at the relative spreads between dollar and euro-denominated funding curves. I presented this chart in that post:

Fast-forward a week, and here’s an update that spans from May 6 to May 14, again using data from the FT:

We should note several things from this update:

First, spreads between dollar and euro funding curves have only compressed – not widened.

Second, the spread between overnight dollar Libor and euro Libor is now negative. So in other words, this point plus my first one highlight that dollar funding needs have only grown – not shrunk.

Third, on May 11, there was a dramatic spike in the spread for overnight euro Libor versus overnight dollar Libor, then it went back to being negative. So my question is this: was there a bank run? The only reason (in my mind, anyway) we would see a spike like that was if depositors were running to the banks to pull their euros out en masse.

I also put these charts together that show how rates have moved from two perspectives: the first shows how these rates all moved through time while the second shows how the yield curve has changed through time. The first pair of charts is for dollar Libor and the second pair is for euro Libor.

The last two charts of euro Libor show that overnight Libor spiked pretty intensely for one day. I went back to May 11th to get a sense of the newsflow, and here’s what I found:

FRANKFURT, May 11 (Reuters) – Deutsche Bank (DBKGn.DE) said European banks could face losses of between 50 billion euros ($63.5 billion) and 75 billion if the debt crisis in Greece continues to escalate and banks are forced to take a “haircut” on Greek sovereign debt.

So Deutsche sees writedowns and haircuts. Shocking. Then there was this from Moody’s:

Moody’s in a “special comment,” called the sovereign debt crisis “unprecedented.” European Union finance ministers agreed to an emergency loan package on Monday that with IMF support could reach 750 billion euros ($1 trillion) to prevent a sovereign debt crisis spreading through the euro zone.

…

“Contagion has spread from Greece — historically a weaker credit in the context of the euro zone — to sovereigns with stronger credit metrics like Portugal, Ireland and Spain,” Moody’s said.

That would’ve moved the market for Greek debt as the last few remaining Greek debt holders – like those who fought under Colonel Custer to the bitter end at Little Big Horn – would’ve been forced to capitulate and have their butts handed to them. Literally.

The company, kept afloat by a bailout and state guarantees in late 2008, said in a statement on Tuesday its exposure to Greek sovereign debt was 3.7 billion euros ($4.7 billion), with little to no exposure to Greek banking, local authorities and corporates.

It added its insurance companies had exposure to a further 1.2 billion euros of Greek sovereign debt, but this was less of an issue for Dexia itself.

Dexia had a 19 billion euro exposure to sovereign bonds at the end of 2009, of which 18 billion euros rated AA or below. It did not give a breakdown per country.

Now, I don’t know much about Dexia, but that sounds like a lot of sovereign debt rated AA or below for one firm to carry. And of that $18bn, almost $5bn is in Greece. But whether they experienced a run or not on the back of this release is unclear. They have a sizable balance sheet at €588bn, so if they got wobbly, it would matter.

Needless to say, Libor funding data is something that bears watching for the short to intermediate term.

EONIA has started to flatten out, particularly dramatic in the long end of the curve. But the front-end remains anchored.

Euribor? Comatose.

And then it hit me…

They don’t matter.

Here’s what matters: the spread between dollar Libor and Euro Libor. I compiled monthly snapshots of the curve going back to the beginning of the year (I love my readers but I’m not compiling 150+ daily Libor curves by hand):

You see it compressing rather dramatically. The reason is dollar Libor has been catching up to Euro Libor. The mad dash for dollars on the European continent is on. So viewed from that perspective, the Euro curves can be shaped any way they want at whatever levels – nobody is using Euros to fund themselves.

And I also noted the TED spread. It’s widening again. The chart is from yesterday, but today’s quote is at 31bps – another 6bp increase:

What makes the spread so disconcerting is this: the last time we saw a gigantic blow-out in the TED spread was before this:

TED blew out before some of these data sets existed. These are all Federal Reserve programs to bolster liquidity in the banking system. They’ve pulled out all the stops, and Fed funds trade around a range instead of a target. Everything that could be done has been done to dampen volatility in short-term funding. And it worked.

Over the past few weeks, when I haven’t been tending to sick family members or fighting off a head cold, I have been noting and pointing out things in the credit/money markets that are giving me pause and reasons for concern. In my mind, there’s a lot to be concerned about and folks focusing on the long end of the curve are focusing on the wrong end, for the wrong reasons.

Why? Because simply put, we’re not through with deleveraging and the forces at work to destroy debt (deflation) will overwhelm the forces to devalue currencies (i.e. inflation). There is still too much debt that has to be repaid, and quite frankly, some of it will not be.

I talked about the credit risk in mortgages that not only exists, but is still increasing. Consider the chart I pulled from the latest Mortgage Metrics report:

Those numbers do not speak of credit risk 5 yrs away, or 10, or 30. By the time you calculate the timing of recoveries and losses, it’s apparent this is an event that is 2 yrs away, at most.

So in building out near-term interest rates, we really need to consider all of the relevant risk premia to add. Default risk, liquidity risk, reinvestment risk, credit spread, and migration risk all come to mind in the near-term as risk premia to pay attention to in this environment. Under normal circumstances, almost all of them would be zero or near zero. But in case you haven’t noticed, well, do these look like normal times to you?

So back to the table above. I can tell you there are three risks that are increasing. Default risk is increasing because of the increases we see in the 90 days delinquent bucket (technically, that’s a default) and the loans in bankruptcy. Migration risk is increasing because as more borrowers migrate from performing to non-performing, it’s another indicator of poor credit performance. Which leads us to spread risk. Because as the first two risks are elevated, spreads over risk-free debt are elevated. Remember when Paulson talked about a “repricing of risk?” Well, that’s what he was talking about. And so Mr. Market comes to a point of recognition. “Holy crap, these things may not pay out!” Thanks for that, Mr. Obvious.

Looking at the preliminary results for the IRA Bank Stress Index for Q4 2009, we do not see any indication that the crisis affecting commercial banks is at an end. Loan loss rates among US banks continue to rise for the twelfth straight quarter in a row. Cash flows from bank loan and securities portfolios alike are still shrinking, forcing further contraction in balance sheets, loan portfolios, cash balances and new loan allocations for bank managers. This is what you call deflation.

But it’s not just the mortgage market and bank balance sheets that are experiencing heightened credit risk. The sovereign debt market has seen these things occurring, too. The PIIGS are suffering from downgrades (i.e. downward migration – a sign of deteriorating credit quality), which probably had something to do with widening spreads amongst developed countries, overall. Is this the same as default risk? No, but downward migration is an indicator that default risk might be on the rise since jump-to-default risk is relatively rare. Tracking migration is important, and having good tools to do that helps. But in looking at rising risks in the developed sovereigns, this points to higher systemic risk as a whole right now. Note that I’m not talking about a bunch of things that are far into the future occurrences, these things are happening right now. Which, again, points to heightened risk at the front-end of the curve, not the back end.

Which means liquidity and reinvestment risk are also on the rise. Because with everyone focused on the sovereign debt of the PIIGS, I’ve been looking for where signs of stress would occur. The banks with the largest exposures to those countries and other sovereign entities strike me as the ones most at risk. This graphic from Bloomberg illustrates the issue quite clearly:

So all in, there’s about $1.4Tn in credit out to borrowers in those countries, and that exposure is found in French, German, Swiss, and British banks. But in looking for signs of stress, they’re not there, yet. But I found a little-known interest rate swap that should show that stress if/when it occurs. It’s the EONIA swap curve. I attached it here so you can see exactly how it works and how it’s used:

The chart below shows what the swap curve looked like at various times throughout the past three years:

You can see that at key moments over the past 3 years, the swap curve was inverted. But in spite of all of the talk about the PIIGS/Club Med countries of Europe, the swap curve has stayed upward sloping. Which is amazing, because even with events like this…

We haven’t seen a spike in liquidity/funding pressures. The question is how long can it stay like this.

If you read FT Alphaville at all (and you should), you get the sense those nice, upward-sloping curves may be a distant memory sometime in the not too distant future. To see what I’m talking about, go here, here, here, and here. There’s an awful lot of talk about liquidity and the draining of liquidity now. China is ratcheting up reserve requirements on banks to curb lending and credit growth, which I alluded to before.

Plus, the Fed is talking about interest rate risk. As the article points out, Fed Vice Chairman Kohn said the following:

“Borrowing short and lending long is an inherently risky business strategy,” Kohn said. “Intermediaries need to be sure that as the economy recovers, they aren’t also hit by the interest rate risk that often accompanies this sort of mismatch in asset and liability maturities.”

Let me illustrate:

So easy, even a banker can do it. But there’s one problem:

Lending to whom? And through what vehicle? It’s not loans to consumers and businesses, which is actually a prudent decision because you don’t save drowning victims by turning on a hose. Plus, credit demand is down. Sure some people say they can’t get credit, but that’s because you have to do more than merely turn oxygen into carbon dioxide to get a loan now. And so, the banks are buying long-dated Treasuries.

So Kohn is worried about funding costs staying as low as they are, for as long as they have. Funding costs/risks are the mirror image of reinvestment risks because with reinvestment risk, the focus is on sustaining the yields you received. Funding risk is the possibility that you’ll have a higher cost of funds tomorrow than you do today. Kohn also had this shot across the bow about losses due to interest rate risk:

“Banks and other investors cannot count on a repeat of the most recent experience — the absence of capital losses when short-term rates rise,” he said.

So if you put together the chart with Kohn’s statement, and you come away with one distinct impression: the Fed is unsure what will happen to the shape of the yield curve when they stop purchasing MBS, and they are openly wondering if the yield curve will invert. From FT Alphaville:

Securitization is fundamentally about one thing: liquefication of the balance sheet. It lowers liquidity risk. So the Fed, through its special programs was aiming to improve market liquidity, which would improve credit conditions overall.

Because liquidity and credit are very much the same issue: the best case scenario is that you get your money back. It’s just with a credit risk issue, it’s a question of repayment over years. For liquidity, it’s a question of repayment over days or weeks. So when viewed in that context, the Fed’s premise is simple: provide ample liquidity at the front end of the curve to instill confidence further and further out. If you take care of the liquidity issues, credit should take care of itself.

Oops…

But I want to go back to Chris Whalen’s Institutional Risk Analytics piece for a minute because he had two very good points. First one is on what the Fed needs to do:

First, we believe that the Fed should end asset purchases in March as planned and then begin to aggressively make a two-way market in all of the securities it holds. The Fed needs to stop pretending to be an “investor” in these securities and start to redefine the private market for MBS by example. As other dealers begin to follow the lead and trade this paper with greater confidence, the Fed can stand back from the markets gradually. The objective here is not to sell the portfolio per se or even make a profit, but merely to restore the secondary market trading and thus improve pricing.

I think this is absolutely correct, but I have my doubts about whether the Fed will succeed in something like this. Because the securitization market is still frozen. Just because you’re the buyer of last resort doesn’t mean the market functions. And why not (emphasis mine)?

To date the entire focus of Fed policy efforts has been to temporarily spare the largest dealer banks from losses on securities and not helping the real economy. This fact is illustrated by the $2 trillion in Fed asset purchases to date. While Fed Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee claim that these MBS and Treasury purchases have helped to keep domestic mortgage interest rates low, there is little indication that these operations are supporting actual credit availability for consumers and businesses at these yield levels. The only “winners” from QE are the financial institutions and foreign governments in Europe and Asia which forced the Fed to repurchase these assets at above-market prices.

So this…

Could very well be a mirage…

Because if the Fed can’t get ask prices that are even close to the bid they put into the market, they stand to lose money. A lot of it. And that balance sheet expansion they underwent would be seen as a total farce.

Which could drive liquidity premiums higher…

And would have some nasty, unintended, and unforseen consequences on the front end of the yield curve as well. And think about this for a second: a 25 or 50bp move will hurt more when your rates are near zero than it will when your rates are at say, 10 percent. It’s a law of large numbers effect.

So back to Chris Whalen’s piece (emphasis mine, again):

As noted above, if the Fed does not soon allow interest rates to rise so that banks and other investors may earn a positive return on assets, the natural process of re-pricing of assets will soon wipe-out any subsidy from the Fed’s ZIRP approach. In a fiat money system, ZIRP implies that paper assets have no value. If the Fed wants to break the deflationary cycle that now threatens the global economy and truly restore investor confidence, then it is time to let interest rates start to rise.

Which I believe is needed, but it won’t be easy, and it sure won’t be smooth. The time for low volatility has passed:

Volatility is returning. Which is something the Fed hates, as this oral testimony from then Fed Governor Laurence Meyer attests to. My comments are in green and I highlighted some important portions:

So needless to say, I’m much more interested with the front end of the curve than the back end because as this should make it clear, the yield curve has been distorted and should still be downward sloping. If you believe this to be the case, there’s really only one question left to ask…

How high will the front end get?

Credit Crunch version 2.0 sure looks primed and ready for release in the coming months. And just think? If this was software, you can’t blame Bill Gates and Steven Ballmer if it fails.